Tales of the Bull and Bear Bond Market

Includes: IEF, TBT, TIP, TLT
by: Kendall J. Anderson, CFA

U.S. Treasury 14.00% due 11-15-2011 issue price 99.303 per $100.00. A year from now, this last great memory of the bear market in bonds will mature. The issue, from November 15, 1981, marked the end of a forty year bear market in bonds and the beginning of the 29 year bull market, which in my opinion is close to an end. This issue also marked a turning point in my investment education that I will share with you.

But first, let’s take a seventy year trip down interest rate lane by reviewing the yields on the 10-Year Treasury, shown in five year increments from the beginning of the great bear market:

The Bear Market, The Bull Market

1941 – 1981 1981 - Present







































Data courtesy of the U.S. Treasury and Robert Shiller.

In November of 1981 I had been in the investment business for two years; my glory days of being young and dumb. Without a mentor, and full of the wonders of a short education and a few successful results (courtesy of others but claimed by myself), I attempted to sell a number of long-term government bonds. After all, I rationalized that I knew more about investing than anyone on the planet and that the current rates offered by the market to borrow money was a sure thing. I had visions of getting rich on the commissions I would be earning from the sale of these bonds, and dedicatedly began calling everyone I knew and everyone I didn’t know, explaining to them the wonders of locking in a high rate of interest for a long period of time.

After hundreds of calls and hundreds of rejections, my inflated ego was soundly deflated. That experience, without my knowing it, was my first lesson in behavior finance. Looking back, it is easy to see that locking in a long-term rate at 14% would have given any buyer bragging rights for the next thirty years, yet every investment is framed by the current state of affairs and the recent memory of investors. With an economy in disarray, double digit inflation, money market rates above 20% and a forty year history of bond market pain, locking in a long-term rate was considered imprudent by the majority of individual investors.

In addition, the respected professionals of the day, those that influenced the attitudes of investors were, as a group, opposed to bonds as an investment. Here is an example of the advice concerning bonds written during that period. It is taken from The Money Masters by John Train, which was published in 1980 with the sub-title “Nine Great Investors: Their winning strategies and how you can apply them.”

The referenced nine great investors are Warren Buffett, Paul Cabot, Philip Fisher, Benjamin Graham, Stanley Kroll, T. Rowe Price, John Templeton, Larry Tisch, and Robert Wilson; a group of individuals that were great then, and for those still with us, continue to be great today.

7. Bonds Don’t Preserve Capital. A final bad deal for the investor, generally, is bonds, unless he reinvests all the income. The notion that they’re “conservative” is grotesquely unrealistic. Franz Pick, in his sardonic way, has called them “certificates of guaranteed expropriation.” After tax, bonds generally yield less than the inflation rate. The present half-life of money is eight to ten years; so, if you spend the income only half your buying power will remain after eight to ten years in real terms, and only one-quarter after sixteen to twenty years. You’ll have run through your capital without even realizing it.

Incidentally, the Dow stocks plus their dividends have vastly outperformed savings accounts, with dividends compounded, over every twenty-year period since 1928, and have more than kept up with inflation.

In 1981, this belief that bonds were a bad investment was pretty much universally accepted by both individual and professional investors alike. The world was full of literature to prove that bonds provided negative rates of return for long-periods of time. Stocks, even though they had produced negative returns for the prior thirteen years, still dominated bonds over the prior twenty, thirty and forty year periods. Contrast that with today. Stock prices, as measured by the S&P 500, have experienced two crashes (excluding the mini crash) and produced zero returns since 1998. Bonds on the other hand have had a positive return. It is no wonder that individuals, frustrated with losses in their equity mutual funds, have been selling stocks and buying bonds en-mass over the past two years.

One of the greatest managers of the decade is Bill Gross, a bond manager. Along with his other managers, his firm PIMCO is at the top of the most influential list of professionals and individual investors in the world today. The only outside manager that PIMCO uses is Rob Arnott, Chairman of Research Affiliates and the creator of the Fundamental Indexes. In April of 2009 he penned an article that received wide coverage titled “Bonds: Why Bother?” The entire article can be found at Journal of Indexes.com. John Mauldin produced a great review of this article. If you are not familiar with Mr. Mauldin, please visit FrontlineThoughts.com and subscribe to his free letter. You will be happy that you do!

In his March 28, 2009 letter Mr. Mauldin highlighted a few items from Mr. Arnott’s article that I am repeating here:

Most people would consider 40 years to be the “long run. So, it is rather disconcerting, or shocking as Rob puts it, to find that not only have stocks not outperformed bonds for the last 40 plus years, but there has actually been a small negative risk premium.

In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium seen in a lot of sales pitches is at best unreliable and is probably little more than an urban legend of the finance community.

How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20 year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the ‘70s.

I picked these on purpose. They are by no means a reflection on Mr. Mauldin, whose letter covers Mr. Arnott’s thoughts in detail. No, I picked these comments because they represent the countless other comments many are basing their justification for selling stocks and buying bonds on today.

Just as a belief that bonds in 1981 were a losing investment based on the prior 40 year bear market, the current belief that bonds are a winning investment based on the prior 30 year bull market could prove to be a disastrous mistake.

“The Trustees’ Dilemma”

Once again I have drawn from the work of John Train, to share with you a story written in 1979 for Forbes magazine. This story was an introduction to the article titled, “The Trustees’ Dilemma”.

A widow was left a substantial amount of money by her husband when he died. The income went to her for life, with the capital to be divided among their three children after her death.

Her late husband had been a successful New York businessman, and the family had two large houses: one in Greenwich, Conn. and one on Cape Cod, where they went in summer. The children liked coming to the Greenwich place on weekends and spending long periods on Cape Cod in summer, so she kept both. As a result, the widow found herself living at the limit of her resources.

At her annual meetings with her trustees, the problem was aired frankly. How could she maintain the houses and keep up roughly the same standard of living as before, with her husband’s considerable salary no longer available? Each year it was decided to sell some growth stocks with low yields and move into bonds or high-yielding equities to maintain the needed income, and hope that all would be well.

So the trust portfolio eventually became roughly half fixed-income securities and half high-dividend stocks, notably utilities and the like.

Unfortunately, however, the investment objective was impossible on its face. At a time when costs are rising 10% a year, income has to rise 12% to 15%, as the tax bracket rises, in order to stay even in real terms.

Now, very few income stocks increase their dividends at anything like 15% a year; as the tax bracket rises, in order to stay even in real terms.

After some ten years of a princely existence, the widow’s buying power in real terms was about 40% of what it had been just after her husband died. The old trustees, friends of her husband, stepped down, and new ones with a more austere and realistic attitude came in. They were dismayed at what they saw. She had to sell both her houses and move into a smaller one, where it was a strain to have any of her children for weekends, since they now had families of their own and came in groups of four or five.

She has many years of life ahead of her, which she will spend in straitened circumstances. If she had cut back right away and adopted a realistic investment policy, she could have been comfortable for her lifetime.

Furthermore, in the future, when the grandchildren come into the inheritance, they will have a justifiable complaint against the old trustee’s if they’re still around. They can’t make out a case at law, but it seems to me that they can certainly make one in common sense and morality. By investing flat out for income at a time of hyperinflation, the trustees knowingly dissipated the corpus of the testator’s estate, and thus did violence to his stated wishes and gypped the remaindermen. When the grandchildren ask what happened to their inheritance, their elders will have to explain that it was essentially blown on high living. In fact the widow herself also has a valid complaint. The original trustees, old business friends of her husband, were paid to give her, the benefit of their realism and experience. Why didn’t they look ahead and set her on a sustainable course?

Our widow in this story relied on experts to guide her in her retirement years. Today, and over the next decade, the great demographic bulge of “baby boomers” will be entering retirement. In an overwhelming force of numbers the current investment advisory business is competing to capture a portion of these individuals’ retirement dollars, offering new products that emphasis income. Given the almost universal “belief” of baby boomers that bonds are safe and stocks are risky; that a guarantee is absolutely necessary; that income, not buying power, is the prudent objective for their investments, the investment communities approach is not unlike our “old trustees”.

Mr. & Mrs. Baby Boomer

Mr. and Mrs. Baby Boomer are both 62 years old and have decided to retire. Combined, they earned $100,000.00 per year and have accumulated approximately $500,000 in savings which is a bit above average. A current rule of thumb is that they will require approximately 78% of their earnings to maintain the lifestyle that they have enjoyed since their kids left home a decade ago in their retirement. They will receive about $2200.00 a month in social security and plan on using their savings for the difference. Let’s see; 100,000 x 78% is $78,000. After factoring in the $26,400 from social security, their plan is to draw $51,600.00 or $4300.00 each month from their retirement savings.

Our “old trustee” is acutely aware of Mr. & Mrs. Baby Boomer’s reluctance to invest in common stocks, so he says that they will invest in bonds with a guaranteed income payment. Because our old trustee is an excellent bond manager, he is able to earn a 5% return through trading in the U.S. Treasury Bond. After all, the 2.5% interest payment on the bond just isn’t enough and his ability to add 100% return is exceptional.

Of course the math doesn’t really change for Mr. & Mrs. Baby Boomer. Our old trustee will someday have to inform his clients that they will run out of money at age 75, even with his superior talent. But then that’s a long time into the future, something good might happen so there is no reason to bring that up just yet. Besides that, most of his clients don’t stay with him that long, so he will just let the “new trustee” take care of this problem.

I am afraid that Mr. & Mrs. Baby Boomer’s experience will turn into reality for the majority of today’s retirees. The greatest risk to any retiree is running out of money before they leave this earth. Most retiree’s understand this, so the idea of an income for life sounds wonderful. However, what good is a guaranteed income payment if the payment is not enough to cover the future costs of living? Today’s retirees must manage their portfolio as if they will live forever. This means they must look ahead and protect their buying power, a risk second only to running out of money. The fact is that interest rates at today’s current level will not provide the necessary income, or the protection against this risk. Failing to account for this would be a tragedy.

Disclosure: No positions